Conduct Of Monetary Policy

During the election
campaign there was significant comment about monetary policy
and speculation about what the Government should establish
by way of an agreement with the new Reserve Bank Governor.
Much of this comment focused on the relationship between the
conduct of monetary policy and its impacts on a balanced
growth strategy that would propel New Zealand into the top
half of the OECD.

Business NZ has had the opportunity to
carefully review recent developments, and to discuss the
conduct of monetary policy with its membership and other
interested parties. We have also reviewed the Australian
experience and the conduct of its monetary policy. This
statement sets out Business NZ's position.

Monetary
policy's contribution to growth

The key, critical role of
monetary policy is to underpin sustainable economic growth
through the maintenance of price stability. Essentially,
effective monetary policy enables the Government's other
policy levers to work more efficiently and encourages the
private sector to invest, spend, and save with confidence.

This is because price stability provides economic
certainty and stability, encourages the efficient allocation
of resources, results in lower interest rates, and provides
a sound platform for businesses to invest with confidence.
For individuals, price stability prevents arbitrary and
inequitable redistributions of assets and incomes, it
protects the 'real' value of their earnings and savings, and
it provides confidence that their purchasing power is not
being eroded.

Exchange rate volatility

New Zealand
has a very high proportion of small exporters (only 1.6% of
exporting firms annually export more than $25 million each),
many of which find it difficult or impracticable to hedge
and therefore find themselves exposed to occasionally large
and sudden fluctuations in the currency. IMF statistics
indicate that between 1989-2001 the New Zealand dollar was
no more volatile than the Australian, Canadian, UK and US
currencies, but there is much anecdotal evidence that
periods of sudden appreciation in the New Zealand dollar
have caused many smaller firms to cease exporting.

While
we acknowledge that the relationship between changes in
monetary conditions and movements in the exchange rate is
often inconsistent with what would normally be expected,
Business NZ urges the Reserve Bank to take greater notice of
the effect exchange rate volatility has on the export sector
when it implements monetary policy.

Danger of looser
monetary policy

Business NZ considers loosening monetary
policy on the grounds that 'a little bit more inflation
would help economic growth' to be a dangerous proposition.
Higher inflation would erode real wages and savings, would
inevitably lead to higher interest rates and a higher cost
of capital, and could cause severe economic distortions.

Increased inflation would further detract from New
Zealand's already inadequate productivity growth and would
actively work against the objective of lifting New Zealand's
rate of sustainable economic growth to above 4%. In our
view, the existing 0-3% inflation target should be
maintained.

Additional objectives

Business NZ does not
consider the Reserve Bank Act 1989 should be amended to
provide the Bank with objectives additional to price
stability. We believe that maintaining price stability is
the best way the Reserve Bank could help New Zealand to
achieve sustainable economic growth.

There is no
evidence that monetary policy has adequate levers to
directly influence objectives other than price stability
unless the Reserve Bank were to be granted the authority to
make policy, for example, on employment or social welfare
matters.

More flexibility

Business NZ supports the
recommendations of Professor Lars Svensson's Review of the
Operation of Monetary Policy. Professor Svensson said that
the Reserve Bank's conduct of monetary policy is "entirely
consistent with best international practice".

While many
of Professor Svensson's recommendations related to
governance issues within the Reserve Bank, he suggested the
Policy Targets Agreement should be amended to explicitly
state that the Reserve Bank's inflation target should be
medium-term.

Business New Zealand supports such an
amendment. We believe that the current wording, which
states that the "target shall be 12-monthly increases in the
CPI of between 0-3%", could imply a short-term focus and
encourage overly rapid and/or pronounced easing or
tightening of monetary conditions.

Our view is that the
target should continue to be stated as a 0-3% inflation
range, rather than an explicit point target of 1.5%, as
suggested by Professor Svensson. Instead, we believe the
Reserve Bank should remain free to interpret a 'target
point' as it sees fit. If a point target were to be
explicitly written into the Policy Targets Agreement then we
believe that a range for 'acceptable outcomes' would also be
needed - this range would be 0-3%.

Although we support
providing an explicit medium term focus, we note that over
the past decade, inflation has averaged around 2%, and more
recently nearer 3%. Therefore, the suggestion that the
Reserve Bank has been fixated on inflexibly targeting the
0-2% or 0-3% mid-points (be they 1% or 1.5%) is simply not
borne out by the experience. The financial markets have
recognised this and expectations of future inflation have
tended to average around 2%, although expectations are now
beginning to nudge higher based on the more recent inflation
record.

Appointment of the next Governor

It is
critical that the next Governor of the Reserve Bank be a
person who is suitably qualified and experienced and has a
high level of credibility in the business community and
financial markets. We would be most concerned if the next
Governor is not perceived to have an explicit commitment to
maintaining inflation within the 0-3% range.

Growth
promoting policies

The conduct of monetary policy is just
one ingredient in an overall recipe to improve New Zealand's
rate of sustainable economic growth. Productivity is the
key, but New Zealand's rate of productivity growth has
consistently lagged behind the likes of Australia and the
United States. This is the single biggest reason for New
Zealand's decline in OECD rankings and our inability to date
to make meaningful progress in reducing the growing gap to
the richest countries.

The incoming Government must be
committed to ensuring that all its economic, social, and
environmental policies are focused on lifting New Zealand's
productivity growth rate, and therefore the country's rate
of sustainable economic growth. Unfortunately, on the
evidence of the election campaign, political parties across
the board inadequately aided public understanding that only
growth could deliver the level and quality of social and
environmental outcomes sought by New Zealanders.

Summary

In summary, Business NZ considers:

* No
amendments to the Reserve Bank 1989 are required;

* The
0-3% inflation target should be retained;

* The
Policy Targets Agreement should be amended to explicitly
state that the 0-3% inflation target is to be a medium-term
target; * The appointment to the position of Reserve Bank
Governor must be a person who is suitably qualified and
experienced and has a high level of credibility within the
business community and financial markets; and * New
Zealand's economic, social, and environmental policies must
be consistent with increasing New Zealand's productivity and
therefore its sustainable rate of economic
growth.

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